The document discusses the relationship between exchange rates and macroeconomic variables. It uses data from Australia, the US, and Germany over 10 years to test 5 regression models linking exchange rates to variables like interest rates, inflation, GDP, and more. The best model is Model B, which indicates that most macroeconomic variables significantly influence exchange rates, except for employment and budget deficit. However, the results show relationships that are opposite of what is theoretically expected, suggesting that psychological factors like investor confidence may dominate over economic variables in impacting exchange rate fluctuations for stable economies.

4. Abstract
 Exchange rates play a significant role in international trade not only in fixing the
prices but also in determining the nature of hedging to be arranged to avoid
exchange rate risks. In this article used three countries yearly exchange rates with
their macroeconomic variables such as relative interest rates etc. to study the
impact they exert on exchange rates.
 Multi models have been applied by linking complementary variables to identify
the best model. The results showed that model B was robust which indicated all
macroeconomic variables significantly influenced the exchange rates except
employment and budget deficit. Most of the macroeconomic variables showed
opposite sign contrary to the expectations and we concluded that the
psychological factors like investor confidence dominate over economic variables
in deciding exchange rate fluctuation.

5. Introduction
 Exchange rate fluctuation is defined as the risk associated with unpredicted
movements in exchange rate. Macroeconomic variables such as interest rate,
inflation rate, the balance of payments, tax rate etc. influence the exchange
rate randomly. These macroeconomic variables are unstable and volatile
depending on the state of the economy prevailing in their countries.
 In addition increased cross border currency flows due to foreign direct
investment and service like banking, insurance, education, tourism cause the
exchange rate fluctuate randomly.
 The role of exchange rate in imports and exports is crucial. In addition a
country’s overall economic performance is reflected by exchange rate .

6. Introduction(cont.….)
 Macroeconomic variables prevail in home and host countries determine
the exchange rate equilibrium in long-run. Short-run fluctuations are
temporary caused by arrival of economic information from time to time
from home and host countries.
 Fluctuations of exchange rate have significant impact on countries’
import and export behavior and ultimately culminate in current account
balance and foreign currency reserves held by the central banks.

7. Introduction(cont.….)
 Exchange rate not only influences imports, exports and direct
investments but also several service sectors like banking, insurance,
education, tourism.
 The Asian economic crisis caused by currency depreciation in the
late 90s and the recent sub-prime loan crisis of 2008 eroded not
only market capitalization of companies but also severely strained
the national economies.

8. Exchange rate & Macro economic
Variables
 Home and host countries’ interest rates play a significant role in
exchange rate determination. The interest rates are adjusted
quarterly by the central bank as part economic management. If
inflationary pressure prevails in the country, the central bank will
increase base lending rate to curtail the money supply among the
people and companies to make borrowings expensive.
 If both home and host countries simultaneously increase or
decrease the interest rates matching, then there will be no effect on
exchange rate due to interest rate.

9. Exchange rate & Macro economic
Variables (Cont.….)
 The increase in the general price level of goods and services in an economy is
inflation, measured by the Consumer Price Index. In other words price raise is
inflation and the same is depreciation of home currency in international parlance.
When the home inflation rate is high the home currency will lose value and vice
versa. Inflation and exchange rate are negatively correlated. A country with lower
inflation exhibits a rising currency value and vice versa.
 A deficit in the balance of payment shows the country is spending more on foreign
trade than it is earning, and that it is borrowing capital from foreign sources to make
up the deficit. The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap enough for foreigners,
and foreign assets are too expensive to generate sales for domestic interests.

10. Exchange rate & Macro economic
Variables (Cont.….)
 Relationship between the employment rate and exchange rate is unclear because
the employment rate can be quantified in several ways. Underemployment issue is
a challenge that could not be quantified with accuracy.
 If the home currency depreciates there will be an increased demand for home
country’s goods in foreign countries which leads to more production in home
country and thus leads to more employment and vice versa.

11. Methodology
 This study investigates nine important macroeconomic variables’
relationship and their influence on exchange rates. Regression modeling
technique is widely applied to estimate coefficients for independent
variables, to test hypotheses and to evaluate the importance of each
independent variable in the model. Following theoretical model to assess
the importance macroeconomic variables.
𝑦 = 𝑎 +𝛽𝑖𝑥𝑖 + … + 𝛽𝑛𝑥𝑛 +𝜀 , 𝑖 = 1,…,𝑛.

12. Methodology (Cont......)
Where
y = Exchange rate
a = Intercept
β= Regression coefficient to be estimated
x = Independent variable
i = List of independent variables
x1=Relative interest rates
x2=Relative inflation rate
x3=Relative balance of payments
x4=Relative employment rate
x5=Relative corruption index
x6=Relative gross domestic product
x7=Relative deficit/surplus rate
x8=Relative tax rate
x9=Relative borrowing rate

13. Methodology (Cont......)
 These variables are closely linked and complementary and therefore a multi
modeling technique is adopted to clearly see the effect of these variables by linking
them as follows.
 Model A will be the traditional model which will include all the nine variables
together
 Model B will link the GDP and budget deficit as they are complementary
 Model C will link the GDP, budget deficit and tax rate
 Model D will link the GDP, budget deficit, tax rate and borrowing
 Model E will link the GDP, budget deficit, tax rate and inflation

14. Data
 To test the above models exchange rates AUD/USD, Euro/USD, AUD/Euro are
considered. These XRs are considered because United States, Australia and Germany
(representative for Euro) are strong economies with minimum unemployment, less
corrupt and lesser deficit in their budgets. These counties faced the recent global
economic crisis more or less on the same level. Data regarding the macroeconomic
variables were collected from the central banks of respective countries. Annual data
was collected for ten years which yielded only 30 data samples. Hence to augment
the sample size the data is bootstrapped to 200. This is acceptable because for most
of the economic variables the data is published annually.

15. Results & Discussion
Fig. 1. Unstandardized coefficients

16. Results & Discussion (Cont.…..)
Fig. 2. standardized coefficients

17. Results & Discussion (Cont.…..)
Table I: Descriptive Statistics of XRs and relative economic variables
AUD/USD EURO/USD AUD/EURO
Mean Std. Deviation Mean Std. Deviation Mean Std. Deviation
Exchange rate 1.224 0.108 0.768 0.058 1.591 0.183
Interest rate 1.471 0.227 0.909 0.105 1.633 0.305
Inflation rate -5.039 19.314 -0.036 2.335 2.358 2.413
BOP 1.074 0.207 -1.203 0.478 -1.067 0.630
GDP 0.167 0.025 1.010 0.141 0.168 0.036
Tax Rate 1.390 0.083 0.899 0.091 1.559 0.161
Borrowings 0.232 0.023 0.900 0.068 0.260 0.038
Deficit/surplus -0.061 0.446 0.345 0.304 2.349 3.587
Employment rate 1.035 0.036 0.989 0.062 1.048 0.029
Corruption Index 1.183 0.035 1.069 0.050 1.108 0.030

18. Results & Discussion (Cont.…..)
Unstandardized S.E. C.R. Sig. Label Standardized R Square
Interest -0.339 0.070 -4.825 *** a -0.349 0.946
Inflation 0.022 0.008 2.851 0.004 b 0.150
BOP -0.088 0.026 -3.388 *** c -0.273
Employment rate -0.535 0.466 -1.148 0.251 d -0.072
Corruption -1.684 0.424 -3.976 *** e -0.278
GDP 0.020 0.277 0.071 0.943 f 0.022
Deficit/Surplus 0.008 0.008 0.940 0.347 g 0.048
Tax 0.399 0.180 2.213 0.027 h 0.328
Borrowing -1.315 0.350 -3.756 *** i -1.118
TABLE II: REGRESSION ESTIMATES OF MODELA

19. Results & Discussion (Cont.…..)
Unstandardized S.E. C.R. Sig. Label Standardized R Square
Interest -0.340 0.068 -4.972 *** a -0.350 0.946
Inflation 0.022 0.008 2.870 0.004 b 0.150
BOP -0.088 0.026 -3.442 *** c -0.273
Employment rate -0.541 0.450 -1.202 0.229 d -0.073
Corruption -1.692 0.388 -4.363 *** e -0.279
GDP 0.008 0.008 0.941 0.346 f 0.009
Deficit/Surplus 0.008 0.008 0.941 0.346 f 0.048
Tax 0.397 0.176 2.26 0.024 h 0.326
Borrowing -1.303 0.206 -6.310 *** i -1.108
TABLE III: REGRESSION ESTIMATES OF MODEL B

20. Results & Discussion (Cont.…..)
Unstandardized S.E. C.R. Sig. Label Standardized R Square
Interest -0.311 0.073 -4.273 *** a -0.320 0.937
Inflation 0.016 0.008 1.998 0.046 b 0.104
BOP -0.123 0.022 -5.566 *** c -0.380
Employment rate -0.315 0.475 -0.664 0.507 d -0.042
Corruption -1.906 0.407 -4.681 *** e -0.315
GDP 0.002 0.009 0.242 0.809 f 0.002
Borrowing -1.700 0.116 -14.668 *** i -1.446
TABLE IV: REGRESSION ESTIMATES OF MODEL C

21. Results & Discussion (Cont.…..)
Unstandardized S.E. C.R. Sig. Label Standardized R Square
Interest 0.311 0.175 1.776 0.076 a 0.321 0.456
Inflation 0.054 0.022 2.494 0.013 b 0.361
BOP 0.019 0.058 0.331 0.740 c 0.060
Employment rate 2.082 1.314 1.584 0.113 d 0.280
Corruption -0.261 1.153 -0.226 0.821 e -0.043
GDP 0.021 0.025 0.845 0.398 f 0.023
TABLE V: REGRESSION ESTIMATES OF MODEL D

22. Results & Discussion (Cont.…..)
Unstandardized S.E. C.R. Sig. Label Standardized R Square
Interest 0.311 0.178 1.746 0.081 a 0.321 0.436
Inflation 0.040 0.017 2.350 0.019 b 0.267
BOP 0.019 0.060 0.327 0.744 c 0.060
Employment rate 1.958 1.332 1.470 0.142 d 0.263
Corruption 0.008 1.142 0.007 0.995 e 0.001
GDP 0.040 0.017 2.350 0.019 f 0.044
TABLE VI: REGRESSION ESTIMATES OF MODEL E

23. Results & Discussion (Cont.…..)
Model CMIN DF P CMIN/DF RMSEA AIC BCC
Model A - - - - - 110.000 177.222
Model B 0.002 1 0.966 0.002 0.000 108.002 174.002
Model C 4.670 2 0.097 2.335 0.215 110.670 175.448
Model D 67.221 3 - 22.407 0.859 171.221 234.777
Model E 68.244 4 - 17.061 0.744 170.244 232.577
TABLE VII: FIT INDICES OF DIFFERENT MODELS

24. Conclusion
 In this research three economically sound relatively less unemployment and less corrupt countries XRs are chosen
to investigate. Interestingly many variables show the opposite relationships. For instance, interest rate, BOP and
inflation rates should influence the exchange rate positively as per theory but the results show the opposite. We
interpret this as true for these reasons:
 Firstly the currency values of these countries are fairly stronger, the strength comes from confidence of public and
investors and not from economic variable prevailing in these countries.
 Secondly the independent variables have complex interrelationships and interactions among themselves which
may not be captured by a weak traditional regression model.
 Thirdly these countries’ economies are fairly corrupt free, stable in interest rates and least unemployment rates
prevail, hence the model gives diametrically opposite results. This may be due to the inclusion of macroeconomic
variables ignoring the psychological factor which is the confidence of investors and traders on the performance or
stability of these economies.